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Stock Bulls Should Exercise Continued Caution


Is there a role for stocks in a diversified investment portfolio? Yes, of course, especially for savvy pros. But the operative word is "savvy."

I have frequently referred to a chart produced by a British analyst, Andrew Smithers (click on "q and FAQs,") who brilliantly (fortuitously) published a book in March 2000 proclaiming stocks to be in the greatest bubble in history -- the very month that the NASDAQ peaked over 5,100.

Every three months, he supplies updated analysis on two of the parameters he and his associates have computed that have historically had a strong track record in predicting the course of stock prices over an appropriate period of time.

These parameters are the cyclically averaged price-earnings (or CAPE) ratio for the past 10 years and a version of Tobin's q – a ratio that measures replacement value of corporate assets, and which he argues more than adequately accounts for intangible but "real" assets such as intellectual property. Here is his updated chart, using data as of September 30, 2011:

Here is his description, with an update to account for stock prices just a bit lower than year-end prices:

With the publication of the Flow of Funds data up to 30th September, 2011 (on 8th December, 2011) we have updated our calculations for q and CAPE. There has been a 1.6% rise in net worth over the quarter, due to a rise of 10.7% in the current value of real estate. This was despite a downward revision to net worth in Q2 2011 of 1.4%, mainly due to an upward revision of 2.8% in debt.

Both q and CAPE include data for the year ending 30th September, 2011. (99% of EPS for the S&P 500 being available by 8th December, 2011). At that date the S&P 500 was at 1131.42 and US non-financials were overvalued by 26.5% according to q and quoted shares, including financials, were overvalued by 37.5% according to CAPE. (It should be noted that we use geometric rather than arithmetic means in our calculations.)

As at 8th December, 2011 with the S&P 500 at 1234.35 the overvaluation by the relevant measures was 38% for non-financials and 50% for quoted shares.

Although the overvaluation of the stock market is well short of the extremes reached at the year ends of 1929 and 1999, it has reached the other previous peaks of 1906, 1936 and 1968.

CAPE measures earnings and q estimates the real value of capital employed (assets) in a business; these are complementary measures. Interestingly, they track each other fairly closely. Eyeballing it and trying to mentally average the two lines over the entire time period, I conclude that stocks have cycled between 0.6 and -0.6 for the past 111 years.

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No positions in stocks mentioned.

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